1/15/2009 @ 9:20AM

The Oracle of Doom

Imagine you are sailing on a dark night in iceberg-strewn waters. The ride is calm. But you are always just a few yards away from disaster. This is how Nassim Nicholas Taleb views the world. The 49-year-old options trader turned bestselling author has been warning about catastrophic market swings for years. And now, in spectacular fashion, he has been proved right. In his 2007 book, The Black Swan: The Impact of the Highly Improbable, he wrote that banks were so connected that “when one falls, they all fall.” He worries that we still haven’t seen the worst. “Everyone is in denial. The car is in the middle of a crash and the parts are still flying, and we don’t know how far they are going to fly,” he says. “The situation is vastly more dangerous than the Great Depression.” Reason: So many more people own stocks now, thanks to the proliferation of 401(k)s.

Taleb isn’t the only one who sensed the impending crisis. But his theories help explain why it happened. The problem with Wall Street, he says, is that (a) it’s in the business of hiding risk and (b) it greatly underestimates the probability of outsize moves. Faulty risk-control models from overconfident economists offered the illusion that we had everything under control and that banks were profitable when they really weren’t, at least not over the course of a full boom-and-bust cycle. The entire financial system is crash-prone and must be rebuilt to make it safer and more stable.

In a long interview, Taleb, relishing his moment, spews forth ideas at a bewildering rate. He mixes angry diatribes against Wall Street honchos with discussions of ancient Greek philosophers and statistical terms like “fat tails.” He dismisses a long list of economists with words like “idiot” or “intellectual fraud.” When asked about those who say there’s little positive in his agenda, he defiantly counters: “I don’t have to respond to any of these critics, not after these events.”

About those fat tails: If you plot a curve of probabilities for different outcomes for stock prices on a ratio scale (so that $100 is equidistant from $50 and $200), you get the familiar bell curve of statistics. It is this curve from which the Black-Scholes options value is calculated. But the real-life curve differs from the standard bell curve in that it has more chances for a big move up or down–fatter tails. Extraordinary booms and catastrophic collapses, that is, are perplexingly common.

Taleb is a man of contradictions. He enjoys the limelight. From his platform as a professor at New York University’s Polytechnic Institute he travels around the world giving speeches, making appearances on TV and promoting his books (the next of which has a $4 million advance). But when a fan of Black Swan comes up to him at a New York restaurant, he gets flustered and pretends she has the wrong person. Extracting information about his personal life is extremely difficult. It appears that he is married, owns houses in his native Lebanon and in Westchester County, N.Y. and reads eight languages.

As an investor (for his own account and for that of a hedge fund firm he advises) Taleb bets on the fat tails. He puts most of the money in Treasurys, then takes side bets on volatility. He sells options that pay off with moderate volatility and buys options that pay off big with big volatility. The strategy has him and long-time investing partner Mark Spitznagel delivering a string of mediocre results interrupted occasionally by spectacular years. Like 2008. His take last year, he says, was in the low eight figures.

Now Taleb wants to be known as a philosopher, not as a trader. The 2007 book explores one big idea: that history is dominated by rare, unpredictable and extreme events. He calls these black swans, alluding to the fact that Europeans had seen only white swans until black swans were found in Australia. The Great Depression, the 1987 stock market collapse and the current financial crisis are examples. Black swans don’t have to be negative. Biotech firms that stumble upon breakthrough cures are black swans.

The human mind, evolved to cope with everyday risks, deals poorly with rare but consequential events. People assume that the future will be like the recent past, but in fact, the most consequential events may not have recent precedents. For economists the problem is compounded by a lack of long-term historical data to study rare events, like nationwide real estate busts. “It’s a fundamental problem with economics,” admits Yale’s Robert Shiller, who says Taleb, unlike most Wall Street pundits, “speaks openly and honestly about the nature of financial risk.”

Taleb wasn’t the first to notice the fat tails on the probability curves. Mathematician Benoit Mandelbrot, known for his work on fractal geometry, noted this property of the financial markets in the 1960s. But he says his paper was ignored because extreme price swings made calculations difficult. “People just cut them away by calling them outliers,” says Mandelbrot, an emeritus professor at Yale University. Taleb independently “figured out that large price changes were much more important than anyone else was giving credit for.”

Taleb scorns math models from economists that purport to explain the markets. All existing models for calculating risk, he says, should be thrown out because they underestimate extreme price swings. “The track record of economists in predicting events is monstrously bad,” he says. “It is beyond simplification; it is like medieval medicine.”

Taleb owes his unusual perspective to his childhood. He grew up in a wealthy Greek Orthodox family in Beirut when it was the Paris of the Middle East. The Lebanese civil war started in 1975, when he was in high school. During mortar attacks Taleb holed up in the basement reading any book he could get his hands on; he still reads as much as 60 hours a week. “I learned from the war that the world can deliver extreme events while people spin stories to convince themselves they saw it coming”–when they really didn’t, he says. Relatives assured him it would be over quickly; it lasted 15 years. His family lost most of its fortune.

After college in France and an M.B.A. from Wharton (and later a Ph.D. at the University of Paris), he went into options trading. In 1985, working at a French bank, he was holding virtually worthless currency contracts that suddenly skyrocketed when the U.S. government reached an agreement with European governments to devalue the dollar. At First Boston, he says, he made $40 million on interest rate options during the 1987 crash.

Taleb considers his literary success a positive black swan. He had trouble finding a publisher for his first popular book, Fooled by Randomness, which details how luck is often mistaken for skill on Wall Street. But it sold well and helped lead to Black Swan, a more literary effort that blends philosophy and history, which spent 17 weeks on bestseller lists.

And what do economists make of this outspoken outlier? The critique from Paul Seabright of the Toulouse School of Economics in France: “He is right that economists have put too much faith in their tools, but he doesn’t stop there; he implies that all the tools are useless.” nyu economist Robert Engle says Taleb draws “precisely the wrong lesson” from the meltdown. “This episode has told us we need to work harder and harder on our risk models–not to ignore them entirely.” Texas Tech University statistician Peter Westfall complains that Taleb, while correct about fat tails, is slippery when it gets to mathematical assumptions underlying his theories. “He simply refuses to be pinned down,” says Westfall.

Such carping infuriates Taleb, who feels that society undervalues those with useful warnings. He does have several proposals for fixing things. He thinks the world would be a more stable place if there were fewer debt instruments and more equity stakes, perhaps along the lines of the Islamic musharaka system of profit sharing. He thinks complex derivatives such as swaps should be banned because they are tools for hiding massive risk. He envisions a two-tier financial system: Banks that might have to be bailed out someday should be treated like utilities and limited to all but the simplest investing and lending activities. Hedge funds that speculate with private money should do so with the knowledge they will never be bailed out again. Retail investors should keep more money in inflation-indexed bonds and not count on the stock market.